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Microsoft's Monopoly Keeps
Firm Sprinting as Rivals Plod

By

Rebecca BuckmanStaff Reporter of The Wall Street Journal

Updated Aug. 8, 2002 11:59 p.m. ET

REDMOND, Wash. -- It's the monopoly, stupid.

Even as rival technology firms are stuck in the mud,
Microsoft
MSFT 1.05%
is in full gear these days, boasting solid sales numbers and unveiling plans for massive new investments. In a recent presentation for analysts and others, for instance, company Group Vice President Jim Allchin flashed a telling visual: a colorful bar graph showing that Microsoft managed to boost sales of its desktop Windows products by 16% last year, while world-wide shipments of personal computers slipped 4%.

The dismal PC numbers were "a pretty big shadow, a cloud over the whole business," Mr. Allchin said from the stage during a daylong conference here. Nonetheless, he said: "We did incredibly well."

What gives? Well, a near recession-proof monopoly, for one thing. Amid the recent stock-market bloodbath, Microsoft's longtime control of the still-lucrative market for desktop operating systems has become even more glaringly evident, economic specialists and fund managers say. It has played a big role in allowing Microsoft to ride out the recession and even raise prices for customers, these people say -- and could mean Microsoft shares are actually undervalued at today's prices.

"When things slow down, [Microsoft] is just in a different kind of fight," says Walter Casey, an analyst and portfolio manager at Banc One Investment Advisors. "These guys are just churning out copies of Windows and getting upgrades from the existing base" of customers, instead of having to search out brand-new customers and hit them up for big sales, he says. "To an organization, their software is almost like water or something ... replacing all of that would be very difficult."

Microsoft, which is fighting antitrust charges in federal court, says it faces plenty of competition from outfits such as
International Business Machines Corp.
and companies peddling products tied to the "open source" Linux operating system, which competes with Windows. Company officials have also said much of Microsoft's recent success stems from the introduction of new products, such as the Windows XP software that made its debut in October. Other, higher-end, Windows products are also often cheaper than competitors', they say. To be sure, the company's profit has been somewhat crimped by the slowdown in PC growth and could suffer more if the trend continues.

Still, the amount of cash being thrown off by Microsoft's core Windows and Office software businesses remains amazing, particularly as many of its competitors grapple with big losses and layoffs.

"They've got a situation where it's almost impossible for anyone to break into that market," says Hal Varian, an expert in the economics of software and dean of the School of Information Management and Systems at the University of California at Berkeley. Mr. Varian says Microsoft benefits from a classic "positive feedback" loop, with unit costs dropping as more products are sold, and the popularity of Microsoft's products making them more attractive to new users.

The upshot: Most customers still don't really have a choice of desktop software, analysts say. Competing products are on the market, but most aren't yet viable.

Listening to many Wall Street analysts interviewed around the time of Microsoft's annual financial meeting two weeks ago, you might not know it. Most declined to use the word "monopoly" when discussing Microsoft's recent success, preferring to talk about the company's "unique market position" or "huge installed base" of customers.

But Jimmy Chang, an analyst and portfolio manager with U.S. Trust, is less reticent. "It's not illegal to be a monopoly," he notes, though it is illegal to use monopoly power unfairly. Microsoft is close to settling many of those issues in federal court, and is already implementing parts of an antitrust settlement reached last year with the U.S. Department of Justice.

Given that, Microsoft shares look like a pretty good buy, Mr. Chang figures. He says he wishes he had bought some last month when they were trading at just under $43 each. Wednesday, Microsoft was at $47.09, up $1.42, in 4 p.m. Nasdaq Stock Market trading. "My feeling is, the stock will move higher," Mr. Chang says.

Banc One's Mr. Casey says the technology fund he co-manages is "overweighted" in Microsoft shares right now, though he declined to say whether the fund has been recently buying. But with a price-to-earnings ratio in the low 20s, plus a cash hoard of nearly $39 billion and no debt, Microsoft "is fairly reasonably or conservatively valued," he says.

Scott Severs, an analyst with Safeco Asset Management in Seattle, agrees that Microsoft shares are attractive right now, saying some investors are too pessimistic about Microsoft's prospects for sales growth.

Though businesses such as Windows and Office will never post the 20% to 30% growth rates they did in the 1990s, they will keep growing, he says.

Other analysts highlight the revenue potential of a new Microsoft software-licensing program for Windows and Office, which went into effect July 31, that essentially forces regular upgrades on existing customers. Microsoft says the program will simplify licensing for customers.

Though Microsoft's stock is down 29% since this same time last year, Mr. Severs notes, the S&P Tech Index is down 44% and a related index of software stocks has dropped 38%. "They're just a powerhouse," he says of Microsoft. "They're growing and no one else is."

There are many reasons for this. One is that Microsoft did introduce several new products last year that sparked new sales, including Windows XP, Office XP and the Xbox video-game console. Xbox contributes to revenue, but is not yet profitable.

The company also has the advantage of selling many cheaper, desktop-computer software products instead of only bigger-ticket items -- such as huge sales-management systems -- that might be too expensive for today's cash-strapped corporate-technology departments, says Thomas Berquist, a senior analyst with Goldman Sachs.

Perhaps more important, some analysts say, is pricing. Over the years, Microsoft has found several ways to charge more money for essentially the same products, or at least products with the same basic code base. Microsoft derives much more money, for instance, from its new generation of Windows products, including Windows NT, Windows 2000 and Windows XP, than it did for older versions such as Windows 95. Microsoft and some analysts note that the newer products are much more stable and contain newer features, justifying their higher prices. Nonetheless, once a new code base is established, it costs Microsoft almost nothing to stamp out new copies of the product.

In addition, Microsoft has tinkered with the way it actually sells Windows and Office over the years to boost profits. Profit margins on Office shot up after the company stopped requiring companies to buy individually packaged copies of the software for each employee and switched to a model that essentially gave companies one copy of Office, allowing them to download it themselves onto employees' computer screens.

More recently, the company has shifted to long-term, multiyear licensing agreements through which customers simply pay a flat rate per PC for continuously updated software. The agreements aim to boost revenue per computer desktop. The newest licensing policy, effective July 31, tries to shift even more people to the multiyear plans and does away with many individual software upgrades, through which customers bought new versions of Windows and Office at their own pace -- usually not as often as Microsoft would like.

That new pricing plan, decried by many of Microsoft's customers, "means a price increase for everybody, eventually," says Alvin Park, an analyst with the research firm Gartner Inc. Banc One's Mr. Casey agrees: "They're trying to force people to upgrade, [though] maybe they'd say 'encourage.'"